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Why Now Might Be the Time to Eliminate a Hardship Distribution Provision

In my experience, most of the retirement plans that are eligible to maintain a hardship distribution provision (defined benefit and money purchase plans cannot, and 457(b) plans can only permit distributions for unforeseeable emergencies, which are a different animal entirely) do indeed allow funds to be distributed for reasons of financial hardship.

The IRS hardship distribution rules are complicated and difficult to administer. For example, events that one might think would qualify as a hardship do not (such as getting out of crippling student loan or credit card debt), and events that one might think would not qualify do (such as purchase of a primary residence), leading to participant confusion.

Fortunately, actual hardship distributions are rare, due to an existing requirement that plan participants exhaust borrowing from all retirement plans of the plan sponsor. Since nearly all plans allow for loans, the vast majority of participants are required to take a loan instead of a hardship distribution, which leads to only a handful of hardship distributions each year, even in the largest plans. Thus, the administrative nightmare that could have been created by a flood of difficult-to-administer hardship distributions has, to date, been avoided.

That is, until now! As you may be aware, the recently released proposed hardship regulations eliminated the requirement that a participant exhaust all available loans prior to taking a hardship distribution. Plan sponsors can maintain the loan requirement, but since they are no longer required to do so, they have a bit of a dilemma: should they maintain a hardship distribution provision that is more restrictive than the minimum legal standard?

In addition, starting in 2020, the proposed hardship regulations (assuming they are finalized as currently written) add a new participant self-certification standard that may prove to be problematic. The new standard states that an employee must represent (in writing, by an electronic medium, or in such other form as may be prescribed by the Commissioner) that he or she has insufficient cash or other liquid assets to satisfy his/her hardship need. The plan administrator may rely on the employee's representation unless the plan administrator has actual knowledge to the contrary.

As noted retirement plan expert Sal Tripoldi has pointed out, that last part about the plan administrator having actual knowledge to the contrary could be an administrative minefield for plan sponsors, as plan sponsor personnel responsible for administration of the retirement plan might be more aware of personal information regarding some employees (e.g., ones working in HR) , but not others. And how would the plan sponsor (and the TPAs/recordkeepers who work with them) determine if knowledge of certain financial circumstances (e.g., an inheritance) would actually mean that the employee has sufficient cash to meet his or her hardship need? Now, it is possible that the final regulations eliminate this provision, but it is also possible that the provision remains as written.

Thus, plan sponsors who allow for both loans and hardship distributions (as most do) have three options:

  • No longer require that borrowing be exhausted in order to take a hardship distribution - While loans remain a better option for participants than hardship distributions, if participants always did what was best for them, we would have nearly 100% voluntary participation in plans. Thus, plan sponsors can expect a large increase in the number of hardship distributions per year under this approach. I suspect that, for most plans, these increases will not be welcomed, since hardship distributions are complicated to administer and communicate to participants (loans are difficult to administer as well, but the communication is more straightforward). I also expect that plan defects related to hardship distributions, which are nearly unheard of at present, will become commonplace if plan sponsors elect this approach.
  • Continue to require that all loans be exhausted in order to take a hardship distribution - While this approach is permitted, employee relations issues may arise as the plan is being more restrictive than the minimum standard under the regulations. Some plan sponsors do not wish to be paternalistic with respect to their retirement plan design, and this provision could certainly be viewed as such. Also, if requiring loans falls out of favor with plan sponsors, there may be some administration issues as many recordkeepers/TPAs are not terribly good at administering provisions that are anomalies among their client base.
  • Eliminate hardship distributions entirely - In addition to administrative issues for plan sponsors, hardship distributions can have terrible consequences for retirement plan participants. Unlike loans, they are fully taxable as ordinary income and subject to a 10% premature distribution penalty if the participant is not at least 59½ years of age (which is the case in nearly 100% of hardship distributions). For an employee in an urban area, this can mean that taxes/penalties will wipe our nearly half the distribution amount. And, even though the participant will only receive as little as half of the money he or she withdraws, all of it is removed from his or her account, and, unlike a loan, is never repaid! For an older individual with a large account balance, a hardship distribution may have a negligible effect on his or her retirement accumulations. However, for everyone else, it is a retirement disaster. This is particularly true for younger employees, where the amount of the distribution will result in an account balance at retirement that is reduced by many multiples of that distribution amount. Sound like fun? Well, it isn’t, which is why the solution of eliminating hardship distribution entirely can be appealing, especially given the new, and potentially problematic, participant self-certification requirement that will become effective in 2020.

As is the case with all plan design decisions, you should consult outside benefits counsel familiar with your plan in order to determine the best option for your organization.

Do you have any thoughts on hardship distributions? Feel free to share your feedback with me via Twitter or at info@cammackretirement.com.

Note: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.

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